China’s Exuberant Irrationality

China’s stock markets—not to mention its real estate market—are in full, irrational exuberance mode. I’ve no idea how long this will continue, when the “bubble” will burst, or if it is really a “bubble.’’ The key thing to remember here is markets can and will overshoot, even if the underlying assumptions driving them up are sound. Recall the Tech “bubble” in the United States. A company like Cisco saw its stock rise ridiculously, then drop like a rock—it hit $13, as I recall( having peaked at well over $100) as the tech bubble burst. But Cisco’s stock collapse hardly meant that the Internet didn’t matter. Pretty much everything that was written about the internet at the time—how it was changing the ways we do business, how it would put murderous pressure on given industries (print media being example No. 1)—were all true. And Cisco’s stock is now back up in over $30 per share.
Similarly with China: a lot of analysts argue, with some plausibility, that this stock market explosion is simply investors—both inside China and out—effectively ratifying the fact that China has become the world’s economic growth engine; that it will be the world’s largest, and thus most influential, economy soon enough, and that there really aren’t any serious obstacle to continued rapid growth here. All of those things are probably true. But they don’t mean that equity prices here aren’t going to collapse at some point (and then recover). Always remember, those are two different things.
Here’s a piece by a friend of mine, Andy Xie, ex of Morgan Stanley, addressing some of this. It appeared in today’s FT, which is a paid site, (www.ft.com) so I’ll reprint it in full here.

The Financial Times

China’s bubble may burst but the impact will be limited

By Andy Xie, an independent economist in Shanghai
Published: October 16 2007 17:42 | Last updated: October 16 2007 17:42

China’s stock market is trading at 50-60 times earnings –we really don’t know the number–and its residential properties are selling for 15-20 times average household income. Many draw parallels between China now and Japan of 1989 or Hong Kong of 1997.
The comparison is wrong. China’s urban residential properties and listed shares in the local and foreign stock market are worth 3.5 times GDP. Both Japan and Hong Kong peaked near 10 before bursting. I am not denying that China’s asset market
is a bubble. Most blame excess liquidity for the bubble. Yes, China’s current account surplus is likely to reach 10 per cent of GDP in 2007. Such a large sum of surplus cash can cause a bubble. But, the government control of asset supply is more to blame for the ridiculous valuation.

For example, all the shares of Chinese companies listed in Shanghai, Shenzhen and Hong Kong are worth Rmb35,000bn ($4,649bn) to Rmb40,000bn, or 146 to 167 per cent of GDP. Over two-thirds of these are owned by government entities. The shares that are liquid and locally listed are merely Rmb9,000bn, or 38 per cent of GDP. China’s stock market is similar to
Nasdaq’s in 2000 when the hot internet companies had ridiculous valuations but small free floats.
In addition to the illiquidity of state-owned shares, tight control over IPOs and share placements are also to blame. The controlling shareholders of privately owned and listed companies cannot sell down their shares even when they think the shares overvalued. Government policy in China deliberately blocks such arbitrages that prevent a market from running away from fundamentals.

The value of residential properties is 4-4.5 times that of the shares that households own. With investment in property construction reaching 10 per cent of GDP, it is a large market in stock and flow. Its high price is due to the presence of extraordinarily large grey income in China –earnings garnered by charging above official prices. Property construction costs less than one third of the sales value. The rest goes to local governments as land sale proceeds and taxes and to property developers as profits. That money tends to circulate among people who have grey income. The higher the property price, the more the grey income.

State ownership in important sectors also generates large grey income. One developer in a second-tier city, when I asked, told me that most buyers at his vast development were teachers, doctors, civil servants and policemen. Teachers get paid by the parents of their pupils for extra care. Doctors raise prices right before putting you on the operating table.

China’s property market is like a squeegee machine on the economy –all its juice is sucked out through all the levers of power and squirted into property. The high monetary value of power and the love of property have combined to make China’s property market large and expensive. Still, the value of China’s residential properties is 1.7 times GDP. Japan’s was 4.5 in 1989 and Hong Kong’s 7.5 in 1997.

China’s asset bubble may burst next week or next year. Your guess is as good as mine. The economic impact, however, will be limited. If the stock market drops by half, households lose 20 per cent of GDP in paper wealth, similar to the impact of a 15 per cent drop of the US market on its economy. If the property market drops 30 per cent, most people in China will laugh; only the rich and powerful will grumble. The banks may suffer bad debts. But the Chinese government has a tendency to pick up the tab after a party and gets
another one going right afterwards. It still has the money to do so.

China’s growth drivers are trade and urbanisation. A US recession could slow down the former. But China’s trade with other developing countries is booming. As all developing countries have excess forex reserves, they can continue to spend in spite of a US downturn. Local governments drive urbanisation. They have just got their new party secretaries who are eager to push ahead. China will continue to build until it runs out of money. The banks have too much money for the foreseeable future.